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FRANKFURT, May 29 (Reuters) - With euro zone economy stumbling this year, risks to financial stability are on the rise, the European Central Bank said on Wednesday, highlighting a long list of vulnerabilities from real estate bubbles to high government debt and Brexit.
Growth in the 19-member currency bloc has slowed sharply over the past year and a global trade war could eat deeper into business sentiment, raising the risk of damaging market volatility.
"Challenges to financial stability increase amid downside risks to the economic outlook," the ECB said in a biannual Stability Report. "Should downside risks to growth materialise, financing costs for vulnerable sovereigns are likely to increase which may unearth debt sustainability concerns."
Highlighting the ECB's concerns, the EU is expected to start disciplinary steps against Italy next week for breaking the bloc's fiscal rules, even as it sits on one of the largest debt piles.
"A lack of fiscal discipline, the delay of fiscal and structural reforms, or even the reversal of past reforms, may reignite pressures on more vulnerable sovereigns," the ECB said without naming Italy but alluding to rises in Italian risk premiums.
Pointing to another risk, the ECB said banks would likely generate a return on equity of around 6% over the next two to three years, with a large share of lenders unable to earn the cost of equity or the 8-10% expected returns required by investors.
Weak bank profits are particularly concerning as lenders transmit most of the ECB's policy stimulus since corporations are more reliant on bank financing than equity markets.
The ECB also warned that residential property markets were showing signs of mild overvaluation, a concern as the post-crisis decline in household indebtedness appears to have slowed down significantly.
To slow the rise, the ECB raised the prospect that it could force banks to hold more capital, topping up national measures, such as countercyclical buffers.
"The ECB is monitoring property market developments too and may top up capital-based national macroprudential measures if needed," it added.
While the euro zone is relatively well prepared for Brexit, Britain's departure without a deal would dent economic growth and likely lead to sharp market swings as investors do not adequately price the risk of such a scenario, the ECB added.
"Combined with an impact via trade channels, potential financial market shocks related to a no-deal scenario pose a material downside risk to euro area GDP growth," the ECB added. (Reporting by Balazs Koranyi; Editing by Alison Williams)